Broad Patterns for the Value Investor

Even for a value investor, sometimes it pays to look at the forest instead of the trees. Recognizing a shift in the wind or a subtle shift in sentiment is just as important as understanding an individual business. After all, it really didn't matter what security you owned at the beginning of 2008 -- when markets drop 40%, that's a headwind that no one can fully escape.

I have observed a few patterns over the past few months that could prove to be far more than subtle. I wouldn't ascribe much weight to them individually, but when I connect the dots, I find that maybe it's time to pay attention. For example, every weekly issue of Barron's publishes a snapshot of 13D or related filings. These filings indicate investment activity of a company's major shareholders (those who have a 5% position or greater). Barron's reveals three categories: new 13Ds (when an investor takes a 5% stake), increases in positions and decreases in positions. For the past couple of months, the level of new 13D filings has tapered off. Furthermore, fewer and fewer investors are increasing positions, while more and more investors are decreasing positions.

Another subtle pattern I like to eyeball is the 52-week high/low list of stocks. Today, the number of stocks coming from U.S. exchanges -- the Amex, the NYSE, Nasdaq and the Over-the-Counter Bulletin Board -- on the 52-week low list is eight. That list of eight names is made of stocks that even the most ardent follower of markets may have never heard of. It includes the $450 million Bazaarvoice (BV) and QuinStreet (QNST).

The 52-week high list counts nearly 300 members, and if you account for stocks that are within 10% of their 52-week highs, the number climbs to the thousands. Again, this is a contrarian pattern, but it gives you a great sense of which way the valuation scales are leaning. And when the 52-week list lacks any names of quality, you know that speculative forces are growing in the market. Last spring, Bank of America (BAC), General Motors (GM) and Deere (DE) popped up on the list.

The stock market's biggest tailwind today is the growing bond market bubble. As investors get nervous about bonds, capital will move out of bonds and into stocks. I believe that trend has been in force in a subtle manner for quite some time now: The stock market has registered a gain for four consecutive years now. And I would suspect that when interest rates do begin to rise, many investors will choose the safety of cash relative to stocks.

In other words, investors should be highly selective today and look out to the next couple of years. High-quality companies such as the automotive technology company Gentex (GNTX) will most likely outperform the market over the next 12 to 36 months. Interestingly enough, shares are about 25% above the 52 week low and 40% below the 52-week high.

The absolute worst pattern you can pay attention to is what the stock market does on a daily basis. So many investors get confident after a market has been on a general uptrend that they forget to consider that the biggest function of stock market returns is price: The higher the price, the lower the future expected return, and vice versa. And right now, a lot of patterns are telling us that prices may be reaching up a bit for the vast majority of stocks.

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Please note that due to factors including low market capitalization and/or insufficient public float, we consider BV and QNST to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.